Hedge Funds Spread Good Cheer to Brokers and Exchanges

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Institutional trading is the main driver behind the continued surge in options volume, and, as with other asset classes, it is hedge funds doing most of the trading. Looking at options trading over the last 10 years, one notices the dramatic shift in the industry's customer base, says a recent report from Aite Group, a Boston-based financial services and technology consultancy. In 1997, 80 percent of total options volume came from retail investors. Today, Aite Group reports, slightly more than half-54 percent-of trading comes from institutions.

The Aite report goes on to say that three forces have "entirely changed the players and the profits" in the options market: an evolving regulatory regime, the advent of electronic trading and the consequent institutionalization of its customer base. To be sure, it was the competition created by the Securities and Exchange Commission requiring multiple listing of options that helped to increase liquidity, giving institutional traders the ability to execute complex options strategies with little market impact. Electronic trading gave them the tools to execute with one click of a button, making it easier to get in and out of large positions.

Goes Pop

A shift in attitudes toward using options began within the institutional trading community after the tech bubble burst in 2000, says Phil Gocke, managing director of institutional research at the Options Industry Council (OIC). These investors realized they needed to protect their portfolios against a downturn, he says. "Options became a desirable method for establishing exposure or protecting against market declines on long-only stock positions," he says.

The surge in options volume stems, in part, from pension funds and endowments shifting to alternative investments in their attempt to gain outsize returns and to diversify investment strategies. Alternative investments could comprise 5 to 15 percent of a pension fund's assets, Gocke says.

For example, Harvard and Yale endowments, with billions of dollars in their portfolios, invest with hedge funds, says Randy Frederick, director of derivatives at Charles Schwab.

The Users

Mutual funds are more tightly controlled. They just dip their toes into options compared to hedge funds," Frederick says. Mutual funds will sometimes have restrictions that don't permit the use of options.

Besides independent hedge funds, the proprietary trading desks at the large investment banks are also large consumers of options on the institutional side of the equation. Options trading is particularly well suited to hedge fund-type strategies, which give these investors the ability to be exposed to both the long and short sides of the market.

Andrew Wilkinson, a senior market analyst at Interactive Brokers, points to an industry study showing that 92 percent of all options are traded in an attempt to hedge a position. Among the options that get the most action are the ones related to three popular exchange-traded funds: the Nasdaq 100, the S&P 500 and the Russell 2000. Both the Russell 2000 and the Nasdaq 100 options trade more than 800,000 contracts a day, while the S&P 500 option trades about 500,000 contracts a day.

"There's just been an explosion in those ETF options," Wilkinson says. "Spreads are narrow, trading costs are down, and trading volumes are through the roof. There's a tremendous amount of liquidity in those options."